In this Edition
Back in mid-March I made the latest of my somewhat rare specific, near-term market predictions, in this case that a US stock market correction or even a crash was imminent. Now some six weeks and a further 5% rally later, I revisit this view. Why, amid surprisingly weak economic data, corporate profit warnings and continued softness in global commodity prices, has the stock market risen to fresh highs? A key explanation is not one that the bulls are going to like: Central banks are increasingly monetizing equities, implying further currency debasement. Investors should thus now begin to deploy idle cash; not in allocations to stocks, however, but to a broad basket of relatively depressed commodities, in particular metals and certain agricultural products.
The (Ongoing) Road to Record Highs
All investors make mistakes but not all investors learn from them. Those that do make better investors. I like to consider myself in this latter category.
Therefore, the time has come for me to evaluate my most recent prediction, from mid-March, that the US stock market was likely to suffer a serious correction or even a crash over the coming weeks. While there was indeed a slight stumble and loss of momentum in April, this has not prevented a net 5% rally in the S&P500 index to 1,630 this week.
For those not familiar with my prediction, here follow some brief excerpts from the relevant Amphora Report, ASSUME THE BRACE POSITION (link):
Year to date, both broad money and private sector credit growth are outright negative even through the monetary base is growing at nearly a 70% annualized rate.[1] The Fed is, therefore, pushing harder than ever before, but still pushing on a string.
Corporate insiders… are cashing out at the fastest rate in years. Many companies are raising new capital through either initial or secondary offerings. Such activity is a sign of a market top…
[F]orward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long.
[T]he current rally has been characterized by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to much research suggesting that a ‘wall of cash’ has been pushing the market higher.[2]
As it happens, each of these cited conditions continues. Alongside a further weakening of broad money and credit growth, leading economic indicators have, on balance, been surprisingly soft. (Remember: jobs data lag, not lead.) By some measures the balance of negative economic data is the worst it has been for over two years.[3]
Is the Stock Market Paying Attention?
Source: S&P; Bloomberg; Zerohedge
Second, realized corporate profits and guidance have continued to miss expectations across most sectors. While this had a negative impact on the specific names affected, the rest of the market shrugged it off quickly and, more recently, even the firms that disappointed, including bellwethers such as Caterpillar and FedEx, have rallied to new highs for the year. Corporate insiders, meanwhile, continue to sell holdings and raise new capital.
Finally, turning to trading volumes, these have continued to decline. Daily market turnover in recent weeks has been only a fraction of the average through the entire rally which began in early 2009.
In my opinion, in this last observation lies to key to understanding why the market has continued to post gains when so many negative factors have suggested at a minimum a pause in the rally and possibly the correction or crash that I predicted.
Normally, a steady decline in volume is understood as an indicator that a given trend, bullish or bearish, may be tiring and due a reversal. But we do not live in normal times. We live in an age of unprecedented policymaker activism. Thin volumes, other factors equal, make it even easier for official agents—primarily central banks—to manipulate markets as a policy tool.
There is nothing conspiratorial about this. After all, central banks set short-term interest rates. They also increasingly set long-term interest rates, both via QE purchases and more subtle mechanisms, such as the ‘duration paradox’ phenomenon associated with a zero-rate policy. (For more on this somewhat esoteric topic please see my report linked here.) From time to time they intervene in the foreign exchange markets. Central banks are also active buyers of gold, or sellers for that matter. But did you know that, in recent months, central banks have also been unusually large buyers of… wait for it… equities!
As reported by Bloomberg News and elsewhere, central banks around the world, including the Bank of Japan, the Bank of Korea and the Swiss National Bank have been unusually large buyers of equities:
Among central banks that are buying shares, the SNB has allocated about 12 per cent of assets to passive funds tracking equity indexes. The Bank of Israel has spent about 3 per cent of its billion reserves on U.S. stocks.
In Asia, the BOJ announced plans to put more of its .2 trillion of reserves into exchange-traded funds this month as it doubled its stimulus program to help reflate the economy. The Bank of Korea began buying Chinese shares last year, increasing its equity investments to about .6 billion, or 5.7 per cent of the total, up from 5.4 per cent in 2011. China’s foreign-exchange regulator said in January it has sought “innovative use” of its .4 trillion in assets, the world’s biggest reserves, without specifying a strategy for investing in shares.[4]
Market Manipulation Is the New Normal
These reports may surprise some, but when you line up what amounts to creeping equity monetization against all the other market-manipulating activities of central banks, including rhetoric expressly supporting rising asset prices as a useful policy tool, then it is just par for the pathological course: Central bankers will stop at nothing to reflate their respective economies in order to avoid any meaningful debt deleveraging and restructuring in their respective financial systems. Yes, some in Germany and a handful of other creditor countries may be putting up some resistance around the margins but the general thrust of policy is clear. And while printing money to purchase government bonds is monetization—unless it is subsequently reversed—printing money to purchase equities is monetization on steroids: It comes closer to an outright ‘helicopter drop’ of money in that it largely bypasses the financial system by directly supporting equity market valuations, providing corporations with a form of ‘currency’ that can be spent on actual, real expansion, acquisitions and job creation.
(For those skeptical that central bank equity purchases are highly relevant, consider the unusually strong relationship at present between central bank balance sheet expansion and the stock market: The correlation has reached 90%. Correlation is not causation but this is strong circumstantial evidence of an indirect link between central bank asset purchases and equity prices. If cenbanks are now switching to direct equity purchases then naturally the indirect link becomes direct and presumably more powerful.)
Still, as with money creation generally, there is no guarantee that the beneficiaries will choose to respond as the central banks desire. Indeed, corporations in most of the developed world are highly leveraged on average, face unusually high tax and regulatory regime uncertainty, and thus remain highly reluctant to invest. (As mentioned previously, some are even choosing to raise capital.)
So while there is zero guarantee that the corporate horses being led to water by outright central bank equity purchases and the elevated valuations they support will act as desired and increase investment, central banks are doing their part to repair what they see as a damaged monetary transmission mechanism by leapfrogging the impaired financial intermediaries.
But is the transmission mechanism in fact damaged at all, or does it largely just reflect a shift in the demand function for money? Keynesians and Monetarists argue the former; Austrian economists the latter. Regular readers of this report will know that I side with the Austrians in this matter and in all matters monetary. Indeed, I would go so far as to argue that the Austrian economic school is the only one that has a consistent or even coherent theory of money, notwithstanding the tangled web of abstruse equations proffered by the mainstream PhDs ensconced in the high ivory towers of academia and essentially non-accountable economic policy making.
In my opinion, the shifting demand function for money reflects the private sector’s efforts to rebuild savings following a series of bubbles, busts and the associated realized and as yet unrealized resource misallocations. Central banks wish at a minimum to halt or ideally outright reverse this reckoning process indefinitely. As I have written before, preventing the realization of resource misallocations by introducing further resource misallocations merely accelerates the deterioration of the economy’s capital stock, leading to outright capital consumption and a permanently reduced standard of living. This is the road we are on.
In any case, as a direct result of unprecedented policymaker activism, the disconnect between lofty stock market valuations and the economic reality on the ground in the US, Europe, Japan and elsewhere grows and grows. Some still dare call this ‘capitalism’ but really, some who do are among those pulling the strings; you’d think they would know better. Perhaps they do and it simply remains their cover story to blame the supposedly ‘free’ market for the escalating failures of interventionism, thereby obfuscating their responsibility for the mess while excusing the next round of Hail-Mary interventionism.
For those who step outside the system and look back at it with unbiased eyes, the dysfunctionality is increasingly apparent. It also goes beyond ordinary politics. As I have written before, the addiction to fiscal deficits and monetary inflationism cross all major party lines in all major economies.
Around the margins, those who do understand the problems are beginning to get themselves organised. The US ‘Tea-Party’ revolt of 2010 was an inchoate example. The ‘Five Star’ movement in Italy has met with considerably greater success. In Germany, the ‘Alternative for Germany’ party has just got off the ground but with much potential. And in the UK, against all expectations, the alternative UKIP party’s support soared in the most recent local elections.
These are observations, not endorsements. None of the parties mentioned above could remotely be called a ‘sound money’ party. But they do demonstrate that the disgust with the inflationist status quo is growing rapidly. The terms of debate are shifting. This is a healthy if at times messy process and is likely to be regarded by future economic historians as an essential part of ending the current economic experiment with unsound, unbacked, manipulated fiat money. As I wrote way back in 2010, “Long may the activism continue.”[5]
Avoid Equities; Accumulate Commodities as a Monetization Hedge
As with nearly all Amphora Reports I try to close with some practical, actionable investment ideas for my readers. In the current instance, the most obvious of these remains to avoid what is now a highly overvalued stock market which remains at risk of an imminent correction. That said, if central banks extend equity monetization then of course nominal price gains can continue indefinitely. These will increasingly come, however, at the expense of real gains, that is, those adjusted for the declining purchasing power of money. At exactly what rate this occurs is unclear but occur it will, and as history strongly suggests, perhaps with little or no warning.
Therefore, it is again time for investors to increase their allocation to that which will hold its purchasing power and which, in real terms, now looks very cheap relative to equities: Commodities. From copper to coffee, gold to grains, sugar to silver, commodities in general look highly attractive given the sharp price declines observed in recent months while the stock market has continued its cenbank-fueled surge.
There are, however, two notable exceptions: crude oil and cotton. Perhaps due to escalating Mideast tensions, crude oil prices have recovered much of their previous losses. I am no specialist on the region but I am well aware that these tensions, should they ease, could lead to sharply lower crude oil prices more in line with those for other industrial commodities, such as copper for example.
As for cotton, it has been a star performer in the tropical products area and several of my proprietary indicators, such as Risk-Adjusted Margin (or RAM; please see here for my report discussing this concept), relative implied volatility-adjusted carry, and available positioning data, all point to cotton having attracted increasingly speculative interest of late. A relative underperformance now appears likely.
The basic Amphora mantra remains unchanged: Real asset diversification is the best insurance against a general global currency debasement. History demonstrates that financial assets generally underperform commodities in such a scenario, as played out during the 1970s, early 1980s and, before that, in the 1920s – 1930s. While we know that history rhymes, rather than repeats, so there will always be differences. But the broader observations and their lessons are rhyming loud and clear for those who have left the Keynesian cave and learned to hear this alternative, non-mainstream verse.
A Few Words About the Amphora Report
In closing, I have now been publishing the Amphora Report for over three years and I’m pleased to see that it has generated a large and increasingly loyal following. While the direct distribution list has growth by the thousands, I have now completely lost control of the indirect distribution via the web, which an internet consultant friend of mine estimates at in excess of 50k hits/edition. I’m pleased and flattered by this on the one hand but, on the other, I’m also aware that those who depend on me to provide quality input into their investment processes would prefer a greater degree of exclusivity. If you would include yourself in this category, please send me a mail and let me know and I will place you on the list.
In future, the Amphora Report will most probably end up operating as a low-cost subscription service and/or as a complementary product freely available to those who engage my various investment advisory services in some capacity. In any case, I take this opportunity to thank all my readers, those who already pay in some way and those who don’t. I do hope that you have found the report worth your while.
[1] To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.
[2] ASSUME THE BRACE POSITION, Amphora Report vol 3 (March 2013). The link is provided in the text above.
[3] For a discussion of this development please see this article from Zerohedge here.
[4] CENTRAL BANKS LOAD UP ON EQUITIES, Bloomberg News, 25 April 2013. The link is here.
[5] This quote is taken from GUESS WHAT’S COMING TO DINNER: INFLATION! Amphora Report vol. 1 (October 2010). Link here.
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